The Basics of Employee Stock Options

No doubt you have heard about stock options before and the stories about how someone became wealthy from the options they held in their startup. If you are wondering how employee stock options work and why they are important for a startup, then this article is for you.

In a separate article, I address the issues that employees should consider about options.

A stock option is the right, but not the obligation, to purchase shares of stock at a specified price at some point in the future. The right to purchase shares at a specified price is known as a call option, because you get to “call” the shares to you (as opposed to a put option, where you have the right to force someone to buy a stock from you).

There are stock options that are granted by a company to its employees as a form of compensation, and then there are publicly traded stock options on public companies. In this article, we are talking about the first type of option, the employee stock option.

Employee stock options grant an employee the right to purchase shares of the company’s stock at a specified exercise price for a defined period. If the company does well and the value of the company and its shares increases beyond the exercise price, then the options are in-the-money and have value if exercised.

Employees who are granted stock options do not have to buy or exercise the options or put any cash forward at the time of the option grant.

Stock options are often provided to founders and employees as part of their overall compensation package. They often compensate founders and key employees for lower cash compensation or salary early in the startup’s life, when cash is scarce, in exchange for the potential of significant gains if the startup is successful. Options are also often provided to regular rank and file employees to provide an additional element of compensation, although the amounts are typically much smaller.

Stock options can be used to align interests and motivations. Being able to share in the upside potential of the company encourages employees to work to make the company successful. However, having a significant portion of compensation tied to stock options can also motivate someone to take excessive risks or manipulate results to artificially increase the value of the company.

For an early employee who was granted employee stock options when the company was smaller and where the company has grown significantly, the difference between the value of the company’s stock and the exercise price can be significant. However, there are also significant tax implications and consequences when exercising options, which will be discussed in a separate article.

The terms of a stock option grant are defined in a legal document known as the stock option plan. The stock option plan lays out key terms of the stock options, including how they vest, their life, conditions for exercising, and what happens to stock options if an employee leaves the company. The stock option plan is typically approved by the company’s board of directors and shareholders.

The company reserves a portion of its total equity to be granted for stock options in a stock option pool. Typically, the size of the stock option pool will represent about 10 to 20 percent of the total equity outstanding if all the options were exercised. The size of the pool tends to be higher in the early stages of the company, before declining to about 10 percent once the company reaches the more mature Series A or Series B rounds. The pool should be sized for the number of stock options that the company intends to use within the next year. When more stock options are needed, the amount reserved can be updated with board and shareholder approval.

Founders need to pay attention to the stock option pool to balance how many stock options are required to provide competitive compensation against the risk of creating excessive dilution. Furthermore, the first grants made by a company and the terms set forth in the stock option plan may create a precedent for future grants.

Stock options also affect the cap table and total valuation. When investors assess valuation, they assume that all potential sources of equity ownership are realized and outstanding, which includes not only stock options but also other sources such as warrants and convertible notes. Thus, the impact of current and future stock options must be factored in when projecting ownership stakes, especially during fundraising rounds.

There are two categories of employee stock options:

• Incentive Stock Options (ISOs) – These are usually granted to founders and key management employees. Incentive stock options enjoy preferential tax treatment if certain conditions are met.

• Non-Qualified Stock Options (NSOs) – Non-qualified options do not meet the requirements to qualify for the preferential tax treatment that incentive stock options do. Non-qualified stock options can be granted to both employees and non-employees alike, including consultants, advisors, board members, and other third parties.

Every employee stock option has some key features:

1. The option exercise price (also sometimes referred to as the strike price)
2. The vesting terms
3. An option life or time to expiration

There is no difference between ISOs and NSOs for purposes of the rest of this article. However, there are significant differences in the taxation of ISOs and NSOs and the impact of these options to employees, which will be explored in a separate article.

The option exercise price is simply the amount that the employee needs to pay in order to exercise the option and acquire a share of the company. The exercise price is fixed at the time the stock option is granted and does not change.

The exercise price is usually set at the fair market value, or FMV, of the company’s stock on the date of the grant. The reason for this is that employee stock options granted at an exercise price below fair market value are subject to immediate tax consequences.

For a publicly traded company, the fair market value is easily observed through market prices. However, for startup and private companies, as there is no public market for their stock independent third-party valuation experts are engaged to conduct a valuation of the company. In the United States, this valuation is referred to as a 409A valuation, named after Section 409A of the U.S. Internal Revenue Code, or IRC.

409A valuations should be obtained before you issue any employee stock options. But if employees are being hired and granted options on a constant basis, does this mean that a 409A valuation needs to be performed before each grant? Possibly.

A 409A valuation is valid for either one year after its effective date, or until a material event occurs. A material event is any event that could change the valuation of the company. Material events could include the unanticipated gain or loss of a significant customer, the departure of a significant founder or employee, changes in the broader economy that affect your business, or acquisitions or strategic partnerships. Therefore, a 409A valuation must be conducted at least once a year.

To avoid having to obtain frequent 409A valuations, some companies restrict their grants to certain times, such as annually or quarterly, or to coincide with board meetings when the board can review and approve the option grants. Granting stock options on regular, predictable dates makes things administratively easier, not only for 409A valuations but also for purposes of tracking the stock option grants. The downside to this approach is that new employees may not receive their grants for some time after they start, which may be more of an issue if grants are only approved infrequently. The company needs to decide how it wishes to balance these two objectives, and it should be upfront with new employees about when stock options will be granted as they are unlikely to coincide with the employees’ start dates.

A 409A valuation can cost anywhere from a few thousand dollars to upwards of $10,000. The first valuation could be more expensive, since the appraiser must collect initial information and background on the company that they will not need for subsequent valuations, assuming the company uses the same provider. It is worth getting proposals from multiple providers to understand how they will conduct subsequent valuations and how much they will charge for them.

Stock options are typically not exercisable by the employee at the time they are granted. There is usually a period of time over which the options become exercisable, known as vesting.

Vesting terms are set by the company and are outlined in the company’s stock option plan documents. There are many variations of vesting terms, but common arrangements are for stock option grants to vest in equal amounts over a three- or four-year period.

One common vesting pattern is to divide the total grant and have an equal number of options vest on the anniversary date of the grant date each year over the vesting period. For example, if an employee is granted 4,000 options on January 1, 2024 with vesting over four years, then 1,000 options would vest on January 1 in each of the years from 2025 through 2028.

Another common pattern is to have a cliff vest for the grant on the first anniversary of the grant date, and then have the remainder vest monthly or quarterly over the vesting period thereafter. Using the same grant as the example above, 1,000 options would vest on January 1, 2025, and then 250 options would vest each quarter until January 1, 2028.

Vesting terms can be structured to help the company achieve its objectives. For example, instead of vesting equally each year over the vesting period, a company can have more of the granted shares vest in later years to encourage employees to stay longer. However, while this strategy may be beneficial for the company, it may discourage employees from staying if there is more uncertainty about the chances of future success.

Most stock options have a life or expiration of 10 years after the date of grant, which is documented in the stock option plan documents. This life is separate from the vesting terms. Stock options are no longer exercisable after their expiration. Any unexercised options essentially disappear and return to the stock option pool, to be available to be granted again.

Most stock options also expire after the employee’s employment with the company ends, even if the options are vested. By law, ISOs expire three months after an employee departure, and many companies adopt the same timeframe for NSOs for consistency. This period is also referred to as the post-termination exercise period (PTEP). Although three months is a common PTEP, companies can offer longer PTEPs for NSOs to attract employees.

Once stock options are vested, they can be exercised by the employee at their discretion up until their expiration date. To exercise an option, the employee pays to the company the exercise price for the number of shares that they want to buy. Not all options need to be exercised at once. The difference between the current share price and what the employee pays is the employee’s profit or gain (less any taxes), but unless the employee can sell those shares, then that gain is unrealized.

For example, if an employee has 4,000 vested options with an exercise price of $3.00 per share, the employee would need to pay the company $12,000 to exercise the options. If the company’s current valuation is $10.00 per share, then the employee’s shares would be worth $40,000, and the employee would have a gain of $7.00 per share, or $28,000 in total. The risk to the employee here is that they must have found the cash to pay $12,000 for shares worth $40,000, but if they cannot sell the shares immediately then they cannot recover their cash investment and there is a risk that the shares could decline in value.

Some option plans may allow for early exercise prior to vesting to allow employees to take advantage of favorable tax treatment. However, shares purchased before vesting are normally subject to repurchase by the company if the employee’s employment ends before the shares have vested.

Once options are exercised for shares, the company adds those shares to the total number of shares outstanding.

Companies should implement a system to track their stock option grants. Since there can be several grants and exercises of options happening at various times, a good recordkeeping system is essential to know how many options are outstanding, how many are vested, how many have been exercised, and how much time remains until the options expire.

At any given time, a company needs to know how many stock options have been granted so that it knows if it needs to increase the size of the stock option pool. The company should also know which employees have exercised options and now have an ownership stake in the company because their votes may be needed for actions that require shareholder approval.

A spreadsheet can be easily set up to track the company’s employee stock options in the early days of the company. As the company grows, someone from the HR or finance department is usually tasked with tracking this information and keeping it up to date. Once the needs of the company outgrow the spreadsheet, the company can transition to a dedicated application or service for administering and tracking stock options. Many of these applications also integrate with cap table management and can support modeling the impact of different events on the company’s equity.

For the company, the treatment of employee stock options is governed by Accounting Standards Codification (ASC) Topic 718, Compensation—Stock Compensation. Under ASC 718, employee stock options are considered equity compensation. There are two components to recognizing employee stock-based compensation:

1. The total expense is measured as the fair value of the equity compensation at the grant date. The amount of the expense to be recorded for a stock option grant is measured as the fair value of the stock option on the date of the grant. For stock options, fair value is typically calculated using a formula such as the Black-Scholes formula, named after the two economists who developed it.
2. The total expense is allocated over the requisite service period, which is typically the vesting period. So for example, if a stock option grant vests over three years, then one way of allocating the expense is to recognize one-third of the expense in each year. The intent here is to match the expense to the timing of the services being provided by the employee.

The fair value of a stock option measured for purposes of ASC 718 is not the same as that measured under a 409A valuation. This is because a 409A valuation measures the value of the company at a given point in time and then allocates that value over the number of shares available, while a formula such as the Black-Scholes model measures the value of the option itself. Since employee stock options represent a right to buy stock of the company in the future, they have what is known as “time value,” which is the possibility that the underlying stock could be worth more in the future.

The expense of employee stock options reduces net income, but as the expense is a non-cash item, it is usually adjusted out of net income when considering valuation. Although the company recognizes an expense for the grant of the stock option, there is no corresponding impact or income to the employees as long as the exercise price of the grant is equal to the fair value of the stock at the date of the grant.

When the expense for employee stock options is recorded, there is a corresponding increase to the equity accounts, even though no new cash investment into the company has occurred.

This article covered several concepts related to stock options. Since stock options are used so widely in startups, a founder and management team must familiarize themselves with how stock options work and understand their impact on the company and its employees.

Employee stock options can be a powerful way to motivate and reward founders, key members of management, and other employees. The way in which they are granted and communicated can be used to help set the tone and culture of the company and emphasize the values that the founders hold important. However, there are many details that founders and management must pay attention to in order to make the company’s stock option plan effective and compliant.